Understanding Section 128 of the Finance Act 2012
Section 128 of the Finance Act 2012 introduced significant changes to the taxation of income from debt funds, specifically addressing the treatment of dividend stripping. Dividend stripping is a tax avoidance strategy where investors buy units of mutual funds (debt funds in this context) shortly before a dividend is declared, receive the dividend (which may be tax-free in the hands of the investor), and then sell the units soon after at a loss, thereby reducing their overall tax liability. The loss incurred on the sale is intended to offset other taxable income.
Prior to Section 128, the dividend income received from debt mutual funds was often tax-free in the hands of the investor, while the loss on the subsequent sale of units could be used to offset other taxable gains. This discrepancy allowed for a potentially significant reduction in the investor’s overall tax burden. The Finance Act 2012 aimed to curb this practice by introducing a specific rule to disallow the loss claimed in such dividend stripping transactions.
The core principle of Section 128 is to restrict the allowance of any loss arising from the sale or disposal of units of a debt-oriented mutual fund if such units were acquired within a period of three months before the record date fixed for dividend declaration, and sold within nine months after that record date. In essence, if you buy units close to a dividend declaration, receive the dividend, and then sell the units shortly after, any loss you incur on the sale will not be allowed as a deduction for tax purposes.
The quantum of loss disallowed is limited to the amount of dividend received on those units. This ensures that the investor cannot artificially reduce their taxable income by exploiting the dividend stripping strategy. The law effectively neutralizes the tax advantage sought through this mechanism.
The intention behind Section 128 was not to penalize genuine investors but to prevent tax avoidance. The three-month purchase and nine-month sale window are designed to target those transactions specifically structured to take advantage of dividend declarations for tax mitigation purposes.
It’s crucial to note that Section 128 specifically targets debt-oriented mutual funds. Equity-oriented mutual funds, with their different tax structures for dividends and capital gains, are not directly affected by this provision.
In conclusion, Section 128 of the Finance Act 2012 plays a vital role in preventing tax avoidance through dividend stripping in debt mutual funds. By disallowing losses arising from the sale of units acquired and disposed of within a specific timeframe around the dividend record date, the law ensures a fairer and more equitable tax system by preventing artificial reduction of taxable income through structured transactions.